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When confronted with a balance sheet recession the math regarding
economic growth gets relatively simple – either the government
spends in times of below trend private sector spending or the
economy contracts. For several years now I have maintained
that we are in a balance sheet recession – an unusual recession
caused by excessive private sector debt. Although this
balance sheet recession created the risk of prolonged weakness I
have been quick to dismiss the persistent discussions that
compare this to anything close to a second great depression -
as I showed in 2009 the comparisons were always
ridiculous. The much closer precedent was Japan, where
the economy actually expanded throughout their balance sheet
recession, but a persistent malaise left a dark cloud over the
private sector as they paid down debts.

Over the last year I have consistently expressed
concerns that the USA was going to suffer the same fate as
Japan, which consistently scared itself into recession due to
austerity measures. At the time, most pundits were
comparing us to Greece and attempting to scare us into thinking
that the USA was bankrupt, on the verge of hyperinflation and
general doom. I wrote several negative articles in 2009
& 2010 berating public officials who said the USA was going
bankrupt and that the deficit was at risk of quickly turning us
into Greece, Weimar or Zimbabwe. Nothing could have been
farther from the truth. The inflationists, defaultistas and
other fear mongerers have been wrong in nearly every aspect of
their arguments about the US economy.

US government default was never on the table, the bond vigilantes
were not just taking a nap and now, with the passage of the most
recent stimulus bill it’s likely that we’ve (at least
temporarily) sidestepped the economic decline that was likely to
accompany a decline in government spending. Richard Koo,
however, believes we are repeating the mistakes of our
past. In a recent strategy note he said:

“The situation in Europe is no different from that in the US. I
therefore have to conclude that the western nations have
learned nothing from Japan’s lessons and are likely to repeat
its mistakes.”

I have to disagree here. The most important factor
impacting economic growth in the prior year was the USA’s ability
to avoid talking ourselves into austerity measures. Unlike
Japan in the 90′s, we have not convinced ourselves that recovery
was here before it was truly sustainable. This was the
single most important contributing factor to Japan’s rolling lost
decades. They suffered from a persistent economic malaise
as the government withdrew aid just as the private sector
appeared to be gaining some traction. And every time this
occurred the economy sunk back into recession. Thus far,
the USA has avoided this trap.

Mr. Koo is unhappy with the passage of tax cuts, which he
believes, will prove far less impactful in boosting the
economy. He also compares the USA to Europe, which I
currently believe is inaccurate. With regards to the tax
cuts, the key during a balance sheet recession is paying down
debt – not propping up the economy via government programs.
Whether this debt repayment is done through unemployment
insurance, jobs programs or tax cuts is relatively
semantic. The end goal should always be the same – to fix
the balance sheets. I think the recent tax proposal is an adequate policy
response given the current state of the US Congress.
It’s not nearly as large as the USA needs and it’s not nearly as
well targeted as it needed to be, however, it’s one of several
things I have asked for in recent years so it would be entirely
unreasonable to sit here and stubbornly say that it is a waste
just because it’s not exactly what I wanted.
Speaking of being reasonable, it is only fair that I admit that
several of my pleas have come to fruition in recent months:

I have consistently pleaded with policymakers to avoid the
fear mongering of the deficit hawks and ensure that we don’t
repeat the mistakes of Japan and 1937.

I have asked for tax cuts that help reduce the strain on
private sector balance sheets.

I have asked for a Fed Chief that would admit that monetary
policy alone cannot fix our woes.

That’s 3 for 3 in terms of several of my big picture requests –
not ideal, but it’s not as bad as it could be. I think
things could be far worse than Mr. Koo makes them out to
be. As for Koo’s concerns that we have not learned from the
lesson of Japan and are increasingly comparable to Europe – I
think that’s a bit off the mark. Europe is forcing
widespread austerity on the periphery nations and the UK has
willingly implemented austerity measures. This is far
different from what the USA is doing. The recent tax
proposal all but guarantees that true austerity is not in the
near future in the USA. His argument regarding Europe’s
response is exactly right, however:

“In Europe, unfortunately, both governments and the private
sector seem to be focused exclusively on fiscal consolidation.
Particularly for the orthodox individuals in charge of the ECB,
the EU and the OECD (by “orthodox” I mean they do not
understand the mechanisms of a balance sheet recession),
fiscal rectitude has become the “only game in town.” They are
oblivious to the fact that austerity is a fundamental
policy mistake during a balance sheet recession.”

Austerity in periphery nations will continue to drag these
countries into economic depression and create extreme risks for
the global economy. The lack of austerity in the USA has
been soundly backed by recent data trends in the USA. The
most notable improvements have been consistent strength in
regional manufacturing data & the ISM data. If we look
purely at a comparison of ISM Manufacturing with GDP the current
levels are consistent with historical GDP growth of just under
4%. This is still largely government/inventory driven,
however, it’s a continuing positive development for a country
facing economic headwinds.

The bad news is, we are Japan, but the good news is we are Japan
on “fast forward”. As I described in mid-2009 everything in the
USA’s balance sheet recession appears to be occurring much more
quickly than it occurred in Japan. So, the good news is
that we won’t need government aid as long as the Japanese needed
it. In the meantime we must remember that stimulus is not
self sustaining recovery. Ultimately, the USA will not be
out of the woods until the private sector begins to meaningfully
expand, contribute to closing the output gap and help reduce the
9.8% unemployment rate. Based on many macro trends I have
said this could be occur as early as 2012, however, any number of
exogenous risks could set us back by months or years. Thus
far, there are some relatively positive signs coming from the
private sector, however, we are still a long ways from sustained
private sector recovery.

For now an accommodative Fed, a $1.3T deficit, a general lack of
austerity and a tepid private sector recovery is likely enough to
sustain economic growth, but not enough to meaningfully close the
output gap. This all continues to point to a period of very
high unemployment, tepid economic growth and a recovery that
feels like a recession. As I said in early 2010 we might be in a technical
recovery, but it still very much feels like a recession with
a 9.8% unemployment rate. The good news is we’re not
talking ourselves off the edge of the cliff. The bad news
is the recovery remains tepid and highly susceptible to exogenous
risks.